16 September 2010

Q: What is economics?A: Economics is the science of how man satisfies his wants. More formally, it is the science of how man produces goods and services, and distributes them.

This is the standard definition of economics. But is it correct?

Economics was born when Adam Smith wrote "The Wealth of Nations" in 1776. This coincided almost exactly with the beginning of the Industrial Revolution (1775–1850). The Industrial Revolution was the second great Revolution in human history, after the invention of agriculture in 10,000 BC. It marked the end of the Agricultural Age and the beginning of the Industrial Age (Modern Age).

The science of economics developed as the Industrial Revolution progressed. The development of economics paralleled (kept pace with) the industrialisation of the West. This is an important point, so obvious that it is overlooked. Economics is a modern/industrial science; it is a science of the Modern/Industrial Age.

Thus economics is not merely the science of the production and distribution of goods and services. It is the science of how goods and services are produced and distributed in a modern/industrial economy.

What difference does it make?, you might ask. There are two differences:1. Economics is built on certain assumptions that are true in an industrial economy – like perfect markets, perfect information, perfect competition. But these assumptions are not true in an agricultural economy.2. Economics deals with industrial economies. It doesn't tell agricultural economies how to industrialise. In other words, economics analyses a steady state. It doesn't tell us how to attain that steady state.

This is classical or traditional economics – the stuff we study in any economics book.

Till World War 2 economists looked only at the industrialised parts of the world: Europe, USA, Japan. It was only after World War 2 that they started looking at the majority of the world that was still agricultural/industrialising. Thus was born a new branch of economics – development economics (or growth economics) – to:1. Deal with agricultural economies, with their imperfect markets, imperfect information, imperfect competition (deviations from the assumptions of classical economics).2. Tell us how agricultural economies can/should industrialise*.

Development economics is a vast and diverse field. It deals with topics as widespread as poverty, inequality, population growth, education, health, agriculture, industry, urbanisation, environment, etc. Thousands of papers are published every year in technical journal journals. But because the subject is so new, vast and diverse, there are very few books that give a comprehensive introduction to it.

The few good books are:1. Economic Growth (2009) – David Weil2. Economic Development (2003) – Todaro & Smith3. Development Economics (1998) – Debraj Ray(I recommend reading them in this order)

Robert Lucas, winner of the Nobel Prize for Economics in 1995, said about development economics:"The consequences for human welfare involved in questions like these are staggering. Once you start thinking about them, it is very hard to think about anything else."Amen.

*This is why growth/development economics is the nearest thing we have to a "science of industrialisation/modernisation".

15 September 2010

In the previous post we identified the key ingredients of economic growth and development. The first/top three are:1. Education2. Health3. Infrastructure

Education-health-infrastructure (E-H-I) – this is the "mantra" for development according to the current discourse in books, newspapers and magazines. Sounds like common sense, doesn't it? Well, not exactly.

It turns out this "common sense" (E-H-I) is a specific school of thought in development economics – the "market-friendly" school. And the market-friendly school/approach in turn is a branch of a broader school of thought – the "neo-classical revolution" of the 1990s.

Anyway, if we accept the E-H-I formula, the questions arises: E-H-I for whom? and where? The discussion/debate on economic policies in India takes place mainly in the English-language media (ELM). This ELM is by and for the middle class of the metros – the metro middle class (MMC). Now the "India" of the ELM and MMC consists of just the 8 metros. So when the ELM says "E-H-I", what it really means is E-H-I for the metros.

So "education" means more IITs and IIMs. "Health" means more super-speciality hospitals. And "infrastructure" means more international airports. This is what education, health and infrastructure mean to the MMC and its mouthpiece, the ELM.

But the metros account for only 7% of India's population. The vast majority of India – 70% – lives in villages. So that is where we must focus. Thus "education" means not more IITs and IIMs, but more primary schools in villages. "Health" means not more super-speciality hospitals, but more clinics in villages. And "infrastructure" means not more international airports – but drinking water, sanitation, roads and electricity for India's 6,00,000 villages.

To increase the wealth created, we must increase the amounts of the inputs. A country grows or develops economically when its factors of production increase. Let us look at each factor.

Land is more or less fixed, so we will ignore it.

Labour has two aspects – quantity and quality. Quantity has no effect on wealth – the increase in production due to more labour is cancelled out out by the increase in consumption. Quality of labour is determined mainly by two things: education and health. The more educated and healthier a worker, the more he/she produces.

Some capital is privately owned, like machines and factories. Some capital is publicly owned, like roads and electricity. Publicly owned capital is nothing but infrastructure, which is provided by the government. Privately owned capital is due to investment, which is funded by savings.

However factors of production by themselves are not everything. How effectively the factors of production are combined to produce output is also important. This effectiveness is called productivity.

Now productivity consists of two parts:a) The knowledge of how to combine the factors of production.b) The effectiveness with which this knowledge and the factors of production are combined.(Yes, there is a little hair splitting here)The first we call technology. The second we call efficiency.

Knowledge/technology is a result of research and development (R&D). Efficiency is an outcome of a country's economic policies and institutions.